Post on 04-Jan-2016
Thorvaldur GylfasonIMF Institute/Center for Excellence in Finance, Slovenia
Course on Macroeconomic Management and Financial Sector Issues
Ljubljana, SloveniaSeptember 21–29, 2011
1.The Great Crash and its consequences
2.What is a systemic banking crisis?3.Main origins of a crisis4.From crisis recognition to crisis
management5.Theories of financial crises6.Policy responses in financial crises7.Banks and incentives8.Twelve lessons from recent crisis
The Great Depression 1929-39 produced a deep slump in output in the US and elsewhere, with dramatic consequences
It also triggered reforms that reduced volatility in output, reducing the likelihood of another great crash Stabilization Stabilization of output Regulation Regulation of banks and other financial
institutions
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Canada had no major bank
failures during Great
Depression, and did not
establish its Deposit
Insurance Corporation until
1967
Change in Canada’s per capita GDP from year to year 1871-2003 (%)
Source: Maddison (2003).
Standard deviation of per capita GDP fell from 6.6% 1871-1945 to 2.3% 1947-2003 Yet per capita GDP growth remained virtually the
same (2.1% vs. 2.2%) In postwar period, active stabilization was the
norm plus careful federal rather than decentralized financial supervision
Canada’s banks are universaluniversal, offering both commercial and investment banking services Even so, recent financial crisis passed Canada by Firewalls between commercial banking and
investment banking were not in place in Canada
How about the U.S. next
door?
Change in US per capita GDP from year to year 1871-2003 (%)
Perhaps bank regulation during
Great Depression also helped
stabilize GDP
Roosevelt-era firewalls between
commercial banking and
investment banking (Glass-
Steagall Act 1933)
Source: Maddison (2003).
Standard deviation of per capita GDP fell from 6.4% 1871-1945 to 2.4% 1947-2003 Yet per capita GDP growth remained virtually the
same (2.3% vs. 2.1%) From the 1960s onward, active stabilization
was the norm, as was federal as well as local financial supervision from 1933 onward
Automatic stabilizers helped From 1870 to 1914, federal expenditures
decreased from 5% of GDP to 2%, rising back to 5% by 1929
From 1945 to date, federal expenditures doubled from 10% of GDP to 20%
Change in UK per capita GDP from year to year 1871-2003 (%)
Not quite as clear to the naked eye, but standard
deviation of per capita growth fell from 3.1% 1831-
1945 to 1.8% 1947-2003
Perhaps bank regulation during
Great Depression also helped
stabilize GDP
Source: Maddison (2003).
Change in French per capita GDP from year to year 1821-2003 (%)
Perhaps bank regulation during
Great Depression also helped
stabilize GDP
Source: Maddison (2003).
Change in German per capita GDP from year to year 1851-2003 (%)
Perhaps bank regulation during
Great Depression also helped
stabilize GDP
Stefan Zweig (1942)Die Welt von Gestern
Source: Maddison (2003).
Perhaps bank regulation during
Great Depression also helped
stabilize GDP
Source: Maddison (2003).
Change in Swedish per capita GDP from year to year 1821-2003 (%)
The emergence of systemic banking crises has been associated with the liberalization of financial systems worldwide
However, since the mid- to late 1990s a number of crises have been of unprecedented scale and consequences: Mexico 1994 Asian Crisis 1997-1998 Russia 1998, Ecuador 1998, Turkey 2001,
Argentina and Uruguay 2002 US 2007 and its aftermath, including Iceland
2008 as well as Ireland as we speak
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A banking crisis is systemic in nature if a loss of confidence in a substantial portion substantial portion of the banking system is serious enough to generate significant adverse effects on the significant adverse effects on the real economyreal economy
The adverse effect on the real economy adverse effect on the real economy arises from disruptions to the payments system, to credit flows, and from the destruction of asset values
Let’s look at some evidence which demonstrates the devastating nature of systemic crises
Banking Problems Worldwide 1980-2002Banking Problems Worldwide 1980-2002
Banking Crisis
Significant Banking Problems
No Significant Banking Problems/Insufficient InformationGreece has a fiscal
crisis, not a banking
crisis
Source: IMF.
Chile
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
1970
1975
1980
1985
1990
1995
2000
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Trend GDP
GDP
Ecuador
150
175
200
225
250
275
300
1987
1989
1991
1993
1995
1997
1999
2001
150
175
200
225
250
275
300
Trend GDP
GDP
Finland
50
75
100
125
150
1980
1984
1988
1992
1996
2000
50
75
100
125
150
Trend GDP
GDP
Indonesia
100,000
200,000
300,000
400,000
500,000
600,000
1986
1989
1992
1995
1998
2001
100,000
200,000
300,000
400,000
500,000
600,000
Trend GDP
GDP
In billions of local currency
Finland Indonesia
Sweden
1,000
1,250
1,500
1,750
2,000
2,250
2,500
1980
1983
1986
1989
1992
1995
1998
2001
1,000
1,250
1,500
1,750
2,000
2,250
2,500
Trend GDP
GDP
Thailand
1,000
2,000
3,000
4,000
5,000
1986
1989
1992
1995
1998
2001
1,000
2,000
3,000
4,000
5,000
Trend GDP
GDP
In billions of local currency
Sweden Thailand
Source: IMF.
Chile
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
1970
1975
1980
1985
1990
1995
2000
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Trend GDP
GDP
Ecuador
150
175
200
225
250
275
300
1987
1989
1991
1993
1995
1997
1999
2001
150
175
200
225
250
275
300Trend GDP
GDP
In billions of local currency
Ecuador
Source: IMF.
Korea
100,000
200,000
300,000
400,000
500,000
600,000
1986
1989
1992
1995
1998
2001
100,000
200,000
300,000
400,000
500,000
600,000Trend GDP
GDP
Norway
500
625
750
875
1,000
1,125
1,250
1976
1980
1984
1988
1992
1996
2000
500
625
750
875
1,000
1,125
1,250
Trend GDP
GDP
In billions of local currency
Korea Norway
Source: IMF.
Need to distinguish betweenCauses and origin of a systemic crisisTrigger of the crisis
Two views (or schools of thought) on origins of systemic crisesInstitutional failure leads to systemic
crisis (classical viewclassical view)Common exposure of financial sector to
certain risks (endogenous cycle viewendogenous cycle view)
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Some weak banks in the system, they stay above water until an external shock hits E.g., weak management, weak risk management
systems, leading to balance sheet deficiencies, mismatches
External shock can be anything (e.g., exchange rate shock, political crisis)
Weak banks go under and, through contagion, pull others into problem zone Crisis become systemic
Helps explain some crises, but not recent ones Source: Diamond and Dybvig (JPE, 1983)
Systemic crisis follows from fact that banks have common exposures to macroeconomic risks
Origin of scenario leading to endogenous cycle may differ from crisis to crisis, but …
… pattern of response is similar I.e., how they get these common
exposures Sources: Minsky (1982), Kindleberger (1996)
Starting point: Economic conditions are considered favorably
Risk evaluation is also favorable Access to credit is relaxed (subprime!) Profits go up Generalized state of euphoriaGeneralized state of euphoria
Anything goes!Anything goes! Boom in asset prices and markets Asset price bubble is forming Risk perceptions remain favorable But, imbalances start to emerge here and there
… … and suddenly the situation goes into reverse
E.g., through a change in mood
Endogenous orself-feeding cycle
Procyclical behavior
(amplification)
The trigger can be anything E.g., change in mood, bad economic or political
news, problems in neighboring countries, rumors Irrespective of origin, a crisis first emerges as
a liquidity problemliquidity problem in one, some, or all banksSymptoms
Bank goes repeatedly to interbank market Bank calls repeatedly upon lender-of-last resort and
requests roll-overWhen the rumors spread, liquidity problems trigger
deposit withdrawals (Asia 1997-98) or credit lines that are being cut (Turkey 2001-02)
Liquidity problems are typically symptoms of symptoms of underlying solvency problemsunderlying solvency problems
Iceland trigger in 2008:
Lehman Brothers’ collapse
Start of crisis often seems chaotic When a problem arises in one bank
Is it an isolated case or will it spread?It takes time to assess situation and
recognize that it is systemicLack of preparedness on the
authorities’ side Vested interests in delaying
recognition, i.e., in avoiding fiscal costs as well as in accepting blame
44
0 10 20 30 40 50 60
Norway 1987-1989
United States 1984-1991
Sweden 1991-1993
Malaysia 1997-2001
Finland 1991-1993
Venezuela 1994-1995
Mexico 1994-1995
Ecuador 1998-2001
Korea 1997-present
Turkey 2000-present
Thailand 1997-present
Chile 1981-1983
Indonesia 1997-present
Sources: IFS, WEO and national authorities.
Gross Cost
Net Cost
Iceland: 64% of GDP
Local stock market was completely wiped out
Financial damage inflicted on creditors, shareholders, and depositors abroad and at home: 7 times Iceland’s GDP, a world record
Fiscal cost of the crisis, including the cost of recapitalizing failed commercial banks and central bank: 64% of GDP
Three “big” Icelandic banks’ collapse in 2008 would, had they been American, make the list of the 10 largest bankruptcies of all time in the US, a remarkable result in view of Iceland’s population of 318,000
Liquidity support If banks prove insolvent, and can’t repay
liquidity support received earlier from central bank
Deposit insuranceGovernment pay-outs as part of deposit
insurance scheme or blanket guarantee Bank recapitalization
Through the government If the government agrees to assist in recapitalizing the banks
through some scheme
Through restructuring of impaired assets A (government) asset management company buys impaired
assets from banks in exchange for government bonds
% of GDP Billions of USD
Liquidity support provided by central bank, and taken over by budget
12 20
Recapitalization, including blanket guarantee
23 40
Purchase of NPLs and capital provided to asset management company
12 20
Interest cost (for the budget)
3 5Total 51 85
How long it takes politicians to recognize that they are face a crisis (+) …
… and the time from the point of recognition to the time of action
Quality of institutions (-) Level of corruption (+) Efficiency of judicial system (-) Restructuring approach (+/-)
Strict vs. accommodating strategy (moral hazard) Types of incentives given during recapitalization
Handling of impaired assets (+/-) Possible payback to government (+/-)
Need for political leadership and coordination
Managing a financial crisis Is a macro-undertaking with lots of
micro-decisions Involves tackling a number of politically
contentious (vested interests), and often technically complex, issues
Involves burden sharing and redistribution of wealth, with most parts of society affected
Economic theories of financial crisis have tended to follow events Different models correspond to specific country cases
Recent theories tend to reflect failure of markets to avert socially costly outcomes, with focus On problems in the markets themselves (particularly in
asset markets) due to asymmetric information/agency problems, etc.
On the role of economic policymakers (esp. central banks) that, in attempting to control credit creation to stabilize economy, unwittingly amplify boom/bust cycles
On why markets do not always produce optimal solutions, see Freefall (2010) by Stiglitz The Origin of Financial Crisis (2008) by Cooper This Time Is Different (2009) by Rogoff and Reinhart
55
Large deficitsCurrent account deficits
Government budget deficits
Poor bank regulationGovernment guarantees (implicit or explicit), moral
hazard
Stock and composition of foreign debtRatio of short-term liabilities to foreign reserves
MismatchesMaturity mismatches (borrowing short, lending long)
Currency mismatches (borrowing in foreign currency, lending in domestic currency)
Increased inequality
-40
-35
-30
-25
-20
-15
-10
-5
0
5
Beyond our means, yes, big time:
Investment (housing, hydro-
projects) Consumption (jeeps, jets, Elton
John)
Mid-2008
End 2008
Pepper, salt,
or gold,
anyone?
Many crises are characterized by over-leveraging Increases vulnerability of debtors to external changes
I.e., risk aversion, interest rate/exchange rate changes
Usually, crises involve debt repayment difficulties for government, households, or corporate sector Debt servicing tends to become harder as crisis
develops Foreign credit dries up, banks need to deleverage, value of
collateral falls, trade credit becomes more difficult, etc.
Does this help crisis prediction or crisis prevention? Extent of debt depends on interest rate/exchange rate What appears to be a manageable situation, proves
unmanageable when variables change Debt levels change and so, too, does bank capital
Net External Debt (% of GDP)*Net External Debt (% of GDP)*
*Excluding risk capital
Mid-2008
End 2008
International Investment Position (% of GDP)*International Investment Position (% of GDP)*
*Including risk capital
Mid-2008
End 2008
Barclays: 100% of Britain’s GDP
Deutsche Bank: 80% of
Germany’s GDP
Source: Union Bank of Switzerland
Increased inequality in distribution of US income and wealth during roaring 1920sBubble conducive to higher incomes
at top end of distribution, and vice versa
Crisis of 2007 Subprime lending supported and made
possible in part as compensation for increased inequality (Rajan)
If so, inequality helped trigger crisis
To restore confidence in a financial crisis, a policy program needs to be announced that is seen by creditors as comprehensive and fully financed
First policy dilemma How to halt pressure on currency while
bolstering domestic demand Should interest rates be temporarily raised? Should fiscal policy be tightened? Should capital controls be introduced?
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Second policy dilemmaShould financial and firm-sector problems be
tackled up front or left until later?Should banks be recapitalized with public
funds? Perhaps no choice Solvency issues Forms of restructuring
Should there be regulatory forbearance?Should public or private debts be
restructured?Should government be involved in corporate
restructuring?
Pros and cons Increasing rates
Helps external adjustment, reduces capital flight
Deflationary when domestic demand is already in decline
Places further stress on over-leveraged firmsMiddle class bonus
Reducing ratesExerts greater pressure on exchange rateObscures/postpones structural problemsCredit supply constrained by banking
problems
“Mistake” in Thailand IMF program 1997Rationale for tighter fiscal policyFiscal space in Iceland program 2008
Fiscal policy in KoreaDifficulty of running a deficitSocial programs in Asia
Fiscal policy in ArgentinaSize of haircut and extent of fiscal adjustment
Preparing for post-crisis vs. getting through the crisis
IMF’s conditional support for fiscal stimulus
Short-run constraints on fiscal policyTime lagsCredibilityType of fiscal action
Longer-term issues of debt sustainability Difficulty of specifying a medium-term
framework in the midst of a financial crisis Different speeds of recovery Impact on potential output
Exit from fiscal stimulusEconomics and politics
Speculation in Asian crisis Experience of Malaysia and Hong KongMalaysian speculationCapital flightDr. Mahathir’s controlsHong Kong and the hedge fund
conspiracyTransparency and regulations against short selling
Source: Finance and Development, September 1999.
Mexico, '93-95
Korea, '96-97
Mexico, '81-83
Thailand, '96-97
Venezuela, '87-90
Turkey, '93-94
Venezuela, '92-94
Argentina, '88-89
Malaysia, '86-89
Indonesia, '84-85
Argentina, '82-83
0 10 20 30 40 50 60Billion dollars
10% of GDP
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
5% of GDP
4% of GDP
Growing acceptance of use of prudential regulations to limit systemic risk in banking system and, more generally, in national and international economyCountercyclical use of prudential ratios
BlanchardLiquidity ratios
Differentiated by currencyReserve requirements
Differentiated by maturityLimitations
Regulatory arbitrage Nonfinancial sector flows
Recent cross-country evidence on effectiveness of capital controls Controls tend to have short-term impact, over
time market participants find ways of circumventing
Controls tend to change composition rather than overall volume of flows
But, Ostry et al. (IMF Staff Position Note 10/04) find that “in the recent crisis the output decline of the countries that had maintained capital controls in the run-up to the crisis was lower than in other countries without capital controls”
There are difficulties in empirical testing – how to measure capital control, what measures introduced at same time, what was counter-factual? Source: Global Financial Stability Report, IMF, April
2010.
Financial globalization is often blamed for crises in emerging markets It has been suggested that emerging
markets had dismantled capital controls too hastily, leaving themselves vulnerable
More radically, some economists view unfettered capital flows as disruptive to global financial stabilityThese economists call for capital controls
and other curbs on capital flows (e.g., taxes)
Others argue that increased openness to capital flows has proved essential for countries seeking to rise from lower-income to middle-income status
Capital controls aim to reduce risks associated with excessive inflows or outflows
Specific objectives may includeProtecting a fragile banking systemAvoiding quick reversals of short-term
capital inflows following an adverse macroeconomic shock
Reducing currency appreciation when faced with large inflows
Stemming currency depreciation when faced with large outflows
Inducing a shift from shorter- to longer-term inflows
Administrative controlsOutright bans, quantitative limits, approval
procedures Market-based controls
Dual or multiple exchange rate systemsExplicit taxation of external financial
transactions Indirect taxation
E.g., unremunerated reserve requirement Distinction between
Controls on inflowsinflows and controls on outflowsoutflowsControls on different categories of capital
inflows
IMF (which has jurisdiction over current account, not capital account, restrictions) maintains detailed compilation of member countries’ capital account restrictions
The information in the AREAER has been used to construct measures of financial openness based on a 1 (controlled) to 0 (liberalized) classification
They show a trend toward greater financial openness during the 1990s
But these measures provide only rough indications because they do not measure the intensity or effectiveness of capital controls (de jure versus de facto measures)
Structural characteristics can sometimes be seen as root cause of a crisis In Korea, exceptionally high debt-equity ratios, low profitability of
corporate sector, and increasing use of foreign currency bank loans to shore up finances in largest chaebol were viewed as indicative of structural problems, including lack of corporate governance, nonstandard accounting rules, directed lending, barriers to entry in various industries, failure of prudential regulation, etc.
But many of these problems had been integral parts of the previously successful model of development
IMF program 1997-98 contained many structural reforms to tackle these problems, some relevant, some dubious The criticism of these structural conditions was that their
implementation prolonged the crisis; they were not immediately necessary.
The counter-argument was that if changes had not been made at that time they would not have been introduced at all
Only in the midst of a crisis could political support be mobilized to effect large institutional changes
The case of Indonesia and crony capitalismToo many conditions, too political
IMF programs and political stability Streamlining of structural
conditionality Recent IMF programs and structural
measures Linkages between structural measures
and macroeconomic stability
Testing banks for solvencyHow big is too big to fail?
Closing banks in the absence of a deposit guarantee Indonesia
Public ownership of private banksWhat conditions are needed?
Purchasing “bad assets”– finding a price
Proposals for regulatory reform in previous crises focused on widening coverage to prevent regulatory arbitrage and separating regulators and enhancing independence of supervision so as to reduce influence of governments and central banks
The theme emerging from the global financial crisis is different in that prudential regulation was seen to pay insufficient attention not only to the risk management techniques of financial institutions but also to the build up of systemic risk
Regulators need to look at a wider view of risk than from focusing on stability of financial institutions in isolation
One proposal is that regulators focus rather on macro-prudential monitoring of the financial system as a whole
While some calls have been made for changes that place regulators back within central banks, other recent proposals (in US House of Representatives, US Senate, UK, EU) call for the creation of councils, each comprising existing supervisory authorities and national central banks within their country (area), that would monitor the buildup of domestic financial systemic risk
For the banks themselves, most authorities see the need for larger capital requirements, particularly for systemically important institutions, i.e., those with high degree of interconnectedness within the system
However, consensus on the modalities of capital surcharges has not yet emerged
Corporate debt restructuring and IMF programsKorea, Indonesia, more recently Latvia,
Iceland Case for government intervention Three different approaches
Case-by-case market-based approachAcross-the-board with direct government
involvement Intermediate approach with government
financial incentives
See Thomas Laryea: Approaches to Corporate Debt Restructuring in the Wake of Financial Crises, IMF Staff
Position Note, January 2010
Government’s role in allocating the costs of a crisisTax policiesSocial programs and redistribution
during crisisSubsidies to financial institutions and
enterprisesSocializing losses and inter-
generational effects Impact of government policies on
future incentives
Insurance and externalities of crisis mitigation
IMF and allocation of costs of crisis between countries
Incentive effects of “bailouts” Future crisis prediction and
prevention
Different causes in each new wave of crises
There are limits to individual country risk analysis
Cross-section econometric techniques
Market Pressure Indices Mecagni et al. (2007)
Index = -(FXt – FXtrend) – ln(NEERt/NEERt-1) + St – Kt
Combines individual indicators FX (international reserves) NEER (nominal effective exchange rate) S (secondary market spread on sovereign bonds) K (net private capital flows as a ratio to GDP)
All variables are standardized with their mean = 0 and their standard deviation = 1
The aim is to show deviations from normal levels of the components
The start of a crisis is identified as the first of two consecutive quarters in which the value of the index is positive
Financial Stress Indicators (IMF, 2008) rely on financial variables for 17 countries
Equal-variance weighted average of seven variables
1. Banking-sector beta2. TED spread3. Inverted term spread4. Corporate spread5. Stock decline6. Time-varying stock volatility7. Time-varying real exchange rate volatility
Financial stress if index is one standard deviation above its trend
Typical Signal Indicators: Overvaluation of currency in real
termsFinancial liberalizationLow output growthFall in asset pricesWeak exportsHigh interest ratesRise in inequalitySee Kaminsky and Reinhart (1999)
Type I and Type II ErrorsBoth probability models and signal
extraction models give too many false alarms
Particularly difficult to get timing right In general, the empirical record of
crisis prediction remains poor, particularly in out-of-sample tests
Desirable elements to help prevent crisesSound macroeconomic policies Sound financial sector regulation
and regular surveillanceSufficient international reservesRigorous debt sustainability analysis
International Monetary Fund. “What Happens During Recessions, Crunches and Busts?”, Stijn Claessens, M. Ayhan Kose and Marco E. Terrones, Working Paper WP/08/274, December 2008
International Monetary Fund. “The Role of Indicators in Guiding the Exit from Monetary and Financial Crisis Intervention Measures —Background Paper”, IMF Policy Paper, January 2010
International Monetary Fund. “Lessons and Policy Implications from the Global Financial Crisis”, Stijn Claessens et al., Working Paper WP/10/44, February 2010
Paul Volcker, Chairman of the Fed 1979-87, said 8 December 2009 at a conference organized by the Wall Street Journal: ““I wish someone would give me one shred of I wish someone would give me one shred of
neutral evidence that financial innovation has neutral evidence that financial innovation has led to economic growth – one shred of led to economic growth – one shred of evidence.”evidence.”
He added that in the U.S. the share of financial services in value added had risen from 2% to 6.5%, and then asked: ““Is that a reflection of your financial Is that a reflection of your financial
innovation, or just a reflection of what you’re innovation, or just a reflection of what you’re paid?” paid?”
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“The Best Way to Rob a Bank is to Own One” When a senior officer deliberately causes bad loans
to be made he does not defraud himselfdoes not defraud himself He defrauds the bank’s creditors and shareholdersdefrauds the bank’s creditors and shareholders,
as a means of optimizing fictional accounting income
It pays to seek out bad loans because only those who have no intention of repaying are willing to offer the high loan fees and interest required
1. Grow really fast 2. Make really bad loans at higher yields 3. Pile up debts4. Put aside pitifully low loss reserves
When the title says it all
Article by Akerlof and Romer:
“Looting: Bankruptcy for
Profit”
Four-point recipe
“The Best Way to Rob a Bank is to Own One” When a senior officer deliberately causes bad loans
to be made he does not defraud himselfdoes not defraud himself He defrauds the bank’s creditors and shareholdersdefrauds the bank’s creditors and shareholders,
as a means of optimizing fictional accounting income
It pays to seek out bad loans because only those who have no intention of repaying are willing to offer the high loan fees and interest required
1. Grow really fast 2. Make really bad loans at higher yields 3. Pile up debts4. Put aside pitifully low loss reserves
The script is from Mel
Brooks’s movie, The
Producers (1968):
A flop pays better than a hit
Four-point recipe
1. 1. Need legal protection against predatory Need legal protection against predatory lending because of asymmetric informationlending because of asymmetric information
Like laws against quack doctors, same logicPatients know less about health problems than doctors,
so we have legal protection against medical malpractice
Same applies to some bank customers vs. bankers, especially in connection with complex financial deals
2. 2. Do not let rating agencies be paid by the Do not let rating agencies be paid by the banksbanks
Fundamental conflict of interestAlso, prevent accountants from cooking the books
3. 3. Need more effective regulation of banks and Need more effective regulation of banks and other financial institutionsother financial institutions
Work in progress, Paul Volcker in charge
88
4. 4. Read the warning signalsRead the warning signalsFour rules, or stories
The Aliber RuleCount the cranes!
The Giudotti-Greenspan RuleDo not allow gross foreign reserves held by the
Central Bank to fall below the short-term foreign debts of the domestic banking system
Failure to respect this rule amounts to an open invitation to speculators to attack the currency
The Overvaluation Rule Sooner or later, an overvalued currency will fall
The Distribution Rule• The distribution of income matters
5. 5. Do not let banks outgrow Central Bank’s Do not let banks outgrow Central Bank’s ability to stand behind them as lender – ability to stand behind them as lender – or borrower – of last resortor borrower – of last resort
6. 6. Do not allow banks to operate branches Do not allow banks to operate branches abroad rather than subsidiaries, thus abroad rather than subsidiaries, thus exposing domestic deposit insurance exposing domestic deposit insurance schemes to foreign obligationsschemes to foreign obligations
Without having been told about it, Iceland suddenly found itself held responsible for the moneys kept in Landsbanki by 300.000 British depositors and 100.000 Dutch depositorsMay violate law against breach of trust
7.7. Central banks should not accept rapid Central banks should not accept rapid credit growth subject to keeping inflation credit growth subject to keeping inflation low low
As did the Fed under Alan Greenspan and the Central Bank of Iceland
They must restrain other manifestations of latent inflation, especially asset bubbles and large external deficits
Put differently, they must distinguish between “good” (well-based, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth
8.8. Erect firewalls between banking and politicsErect firewalls between banking and politicsCorrupt privatization does not condemn
privatization, it condemns corruption9.9. When things go wrong, hold those When things go wrong, hold those
responsible accountable by law, or at least responsible accountable by law, or at least try to uncover the truth: Do not cover uptry to uncover the truth: Do not cover up
In Iceland, there have been vocal demands for an International Commission of Enquiry, a Truth and Truth and Reconciliation CommitteeReconciliation Committee of sorts
If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself
Public – and outside world! – must knowNational Transport Safety Board investigates every
civil-aviation crash in United States; same in Europe
10. 10. When banks collapse and assets are When banks collapse and assets are wiped out, protect the real economy by a wiped out, protect the real economy by a massive monetary or fiscal stimulusmassive monetary or fiscal stimulus
Think outside the box: put old religion about monetary restraint and fiscal prudence on ice
Always remember: a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth Physical capital (typically 3 or 4 times GDP) and
human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP)
So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth, or less
The structure
can withstand
the removal of
the top layer
unless the
financial ruin
seriously weakens the
fundamentals
Even so, tremendous damage in
Iceland, equivalent
to up to 7
times GDP
11.11. Shared conditionality needs to become Shared conditionality needs to become more commonmore common
As when the Nordic countries providing nearly a half of the $5 billion needed to keep Iceland afloat imposed specific conditions on top of the IMF’s conditions
This has come up again elsewhere E.g., in Greece now that the EU and the IMF have
been called on to support Greece together For this, clear and transparent rules tailored
to such situations ought to be put in place
12.12. Do not jump to conclusions and do Do not jump to conclusions and do not throw out the baby with the bathwaternot throw out the baby with the bathwater
Since the collapse of communism, a mixed mixed market economymarket economy has been the only game in town
To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized
Even so, it remains true as a general rule that banking and politics are not a good mixbanking and politics are not a good mix
But private banks clearly need proper regulation proper regulation because of their ability to inflict severe damage on innocent bystandersinnocent bystanders
Do not reject economic, and legal, help from abroad
The EndThe End